KIND - Nextdoor: AI To Improve User Engagement And Quality Of Posts

2023-06-18 08:25:28 ET

Summary

• Nextdoor Holdings focuses on neighborhood-based social networking and has been investing in AI and machine learning to improve user engagement and content quality.
• The company has achieved high gross margins but struggles with high operating expenses, making it unprofitable compared to competitor Meta.
• Despite its potential, Nextdoor is not a recommended buy until operating expenses decrease sustainably, and it is better suited for a watchlist.
• As user-generated content is particularly attractive for Generative AI applications, it can help the social network company.

Imagine Meta Platforms (META) or Facebook as it was called before the metaverse rebranding and stripping it of fake accounts and more focused on neighborhoods, and you have Nextdoor Holdings, (KIND).

Now, contrary to actual accounts, fake ones are created with malicious intent, and I do not imply that Nextdoor has none, but it certainly has less given its approach to better screen potential members. This strategy also enabled it to grow at an incredible pace of 37% CAGR in the last three years, but there was a significant deceleration as seen in the table below.

To address the issue, a number of measures have been taken, one of which is the use of Generative AI and my aim with this thesis is to assess whether these can deliver results, as well as focus on profitable growth. For this purpose, I will use data mostly from the first quarter 2023 (Q1) earnings call transcript .

First, for a social networking company that started from word of mouth, before growing its community of users initially from the United States, before expanding in the rest of the world, it is important to understand the growth model in order to grasp how it can benefit from intelligent IT algorithms.

Understanding the Growth

In order to explain the rapid growth seen in 2020-2021 as per the above table, it was all related to the pandemic, which was particularly beneficial to the Nextdoor mobile app. In that context, in a society predominantly governed by individualism and social networking, living in the midst of a health crisis provided opportunities to socialize with one's neighborhood and be exposed to the realities of the members of one's community.

As a result, many chose social media to stay connected rather than remain isolated. Also, instead of interacting with people thousands of miles away, priority was given to gaining knowledge of what was happening in the neighborhood, with many opting for Nextdoor's app instead of Meta's Facebook. In a way, connecting virtually represented an alternative to infection-prone physical interaction and enabled people to introduce themselves to their neighbors and establish initial contact with them, with the trend continuing to this day. Going a step further, many users seek advice as to the best takeaway restaurant or look for the contact details of a residential electrician.

Going beyond the mutual aid paradigm whereby neighbors share information about a potential thief roaming in the vicinity, Nextdoor also features advertisements about good bargains sitting right next door. It is precisely this more regional approach that differentiates it from its larger peer as it enables advertisers to tap into a more targeted customer base, instead of resorting to more expensive nationwide digital billboards.

However, as evidenced by sales figures, even such a business model has its limits with Covid gone and people resuming their previous lives. Hence, the year-on-year quarterly revenue progression in the blue chart shows that after increasing in 2021, growth has been much more subdued. The same has happened to competitor Meta as illustrated in orange .

Other factors like a slowing economy have also contributed to lower sales.

Overcoming the Challenges through AI

The challenge is therefore to sustain virtual interactions and one of the solutions is using more personalized notifications, which take into consideration users' tastes and browsing habits. Another solution is to make content more dynamic depending on the specific use case, for example, providing a wider geographical view when someone is searching for a service provider for installing a new camera system, and, conversely, narrowing it down when looking for a pet to adopt during the weekend.

Now, in order to attain both of these objectives, the company has already been investing in AI and machine learning to deploy what is termed as “sentiment analysis”. These tools have already been available for years and used mostly by advertisers to perform customer profiling in order to identify products most likely to be purchased. Such analytical tools are commonly grouped under Recommendation AI.

Talking monetization, investors will note that using a combination of AI and focus on certain industry verticals like healthcare as a recession-resistant sector, as well as expanding into new markets, all have led to a recovery in Q1 after the trough suffered in the December quarter as evidenced by the above blue chart.

Therefore, the company has already been investing in analytics and machine learning to deepen user engagement, which raises the question of what Generative AI can deliver. Well, leveraging on its ability to “generate” better summaries and reports, the company has started using the technology to improve the quality of user posts, namely to make them more engaging to viewers in terms of attributes like kindness. The intent is also to encourage members to be more constructive when postings, with these attributes chosen after a careful study of the data available on what works well depending on the neighbor's previous preferences. However, no timeline or figures has been provided as to the growth envisaged.

Here, one of the advantages of Nextdoor just like Meta is its large database consisting of over 80 million verified neighbors. Also, despite revenue growth stalling, WAU or Weekly Active Users grew by 16% year-over-year in Q1 which signifies a vast and dynamic repository of data across which AI algorithms can dice through and learn in order to identify techniques to promote engagement.

Loss-Making, But Trying to Contain Costs

However, again coming to monetization, this time profits, while gross margins exceeding 80% have been sustained during the last two and a half years, which, by the way, are even better than Meta, operating margins have shown no sign of improvement. The main reason for this is spending a lot of money for growth with SG&A (or Sales, General, and Administrative) expenses as a percentage of revenues exceeding 90%, signifying that for every dollar of sales, 90 cents is consumed by SG&A. There is more, with research expenses also remaining staunchly high, at over 60% of revenues. Both have resulted in operating costs above 150% as shown below.

To this end, with the ramping up of the advertising platform and investment in AI involving new members added to the product development team, we are far from cost-cutting measures that can provide fast relief to margins.

Still, if one takes the time to look at the evolution of operating expenses as shown below, it has been flattening thanks to higher customer acquisition efficiency. Additionally, expenses are being prioritized for go-to-market initiatives.

Looking at the balance sheet and considering that the company ended Q1 with $575 million in cash, there is enough money to run operations for more than one year considering that operational expenses totaled $321.5 million in FY-2022, but, more is needed on the growth side.

For this purpose, in addition to healthcare, Nextdoor is also tapping into sectors like government, tech as well as telecom services which are more resilient to a potential recession. It has also been working on optimizing what revenues advertisers can earn when listing on its platform through the provision of real-time measurement tools provided by the likes of Foursquare for marketing campaigns and Neustar for brand marketers. These actions have helped to sustain advertisers' retention rates.

More Progress Needed Before Buying

However, despite, all these positives and its lower price-to-sales metrics compared to Meta as pictured below, Nextdoor is not a buy until its operating expenses do not decline in a sustainable fashion, as these are still on the high side. For this matter, being a cash-burning company, any increase in expenses may reduce the amount of cash available for business operations. Now, with a debt-to-equity ratio of only 11.87% , Nextdoor should not encounter any problem getting bank loans, but interest rates remain high. Consequently, it should continue to favor a more profitable growth strategy.

In conclusion, this thesis has shown that Nextdoor is leveraging analytics to enhance engagement, with user-generated content being particularly attractive for Generative AI applications. This in turn encourages more advertisers to list their products on the social networking site signifying better monetization prospects. In addition, the specific industry verticals on which it has focused have proved beneficial. As a result, it is likely to meet or even beat revenue estimates of $226.7 million for FY-2023 which entails a 6.55% growth over last year, unless a recession hits the U.S. economy in the second half.

However, it is not profitable like competitor Meta and this is not likely to change any time soon as cost-containment measures have been prioritized over cost-cutting. In these circumstances, till it does not sustainably improve its loss-making status, it is more of a stock to put on your watchlist.

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